R3: More Supply Chain Woes

R3: REQUIRED RETAIL READING

August 20, 2010

Another day with supply chain issues in the headlines, this time the Indian subcontinent in focus. Other headlines include Taiwanese growth opportunities, a sweet spot for men’s suits, DKS, SPLS, and… Groupons???.

RESEARCH ANECDOTES

- Yesterday’s Groupon (if your not familiar Google it) proved so popular it took the site down. The group coupon website offered a deal for The Gap, which gave users $50 in spending power for the price of $25. At 50% off, we’re not surprised the demand was off the charts.

- Dick’s Sporting Goods expressed enthusiasm for an upcoming marketing push from Reebok aimed at re-energizing the toning category. Management continues the believe the “category has legs”. Not sure if the pun was intended.

- Dollar Tree noted that they are not seeing rising costs out of Asia on their merchandise, despite what other retailers are reporting. In fact, a recent buying trip to Asia resulted in a products with higher IMU’s and improved values for their customer. Management also noted that the company’s business model is not wedded to any specific items and as a result, leaves the company with more direct control of merchandise mix and margins.

- Staples noted that it expects back to school to be as promotional as in prior years. Management is pleased with the season so far, but cautions there are still several big weeks ahead in the BTS season.

OUR TAKE ON OVERNIGHT NEWS

Supply Chain Crisis Looms - Fashion retailers and brands are facing a supply chain crisis as the Indian subcontinent grapples with a triple whammy of natural and man-made disasters and political unrest, which threatens to disrupt deliveries and heap further pressure on costs. The devastating floods in Pakistan have so far destroyed up to 30% of the country’s cotton crops after 700,000 acres of cropland was submerged. This has compounded a string of problems in the region, including the closure of the port of Mumbai in India last week and strike action over low wages at factories in Bangladesh. The result is uncertainty and volatility in terms of deliveries and a forced increase in freight costs to transport stock by different means, including air freight, to the UK and US. Vital overland and shipping routes in Pakistan were blocked soon after the floods started on July 31. Meanwhile, a container ship in the busy port of Mumbai shed its load after colliding with a steamer on August 7, bringing the crucial fashion transport hub to a halt. Both events are set against the backdrop of continuing riots at factories in Bangladesh, where between 10% and 20% of factories in the country have been closed while a new minimum wage threshold is thrashed out. The supply chain disruption could lead to retailers piling into Sri Lanka to pick up the shortfall. But sources said the country’s infrastructure could not cope with extra demand. <drapersonline.com>

Hedgeye Retail’s Take: When it rains it pours. Interestingly, many retailers that have reported 2Q so far appear to have had their early Fall shipments already in place or on the water. Regardless, this should have both cost and inventory implications as the season unfolds. Possible benefits for off-price as supply chain disruptions normally lead to opportunity.

Consumer Seen Inching Toward Full-Price Stores - The on-again, off-again economic rebound has created a limbo of sorts for retailers, where those consumers who have held onto their jobs are still interested in low prices but are also looking for a bit more. The immediate beneficiaries now appear to include the large, well-funded giants that are stocking up on targeted and exclusive offerings. In contrast, off-pricers, which found themselves in vogue during the recession, continued to click along in the quarter, but their armor showed signs of cracking. <wwd.com/business-news>

Hedgeye Retail’s Take: We’ve long maintained that off-price strength would eventually wane, but we think this has more to do with inventory in the marketplace vs. consumer tastes.

Specialty Retailers Show Weak Spots in Q2 - Thursday’s second-quarter results posted by specialty chains for the period ended July 31 were mixed. ARO management was not pleased with the sales and margin performance in the latter half of the period. BKE experienced a slight increase in the sale of marked down merchandise and an increase in loyalty card redemptions driving gross margins down. NWY fashion missteps and deep discounting widened its loss with additional pain from softness in T-shirts, dresses and shorts.<wwd.com/business-news>

Hedgeye Retail’s Take: Rising inventories coupled with increased promotions=more risk over the rest of the year. Teen retail is especially under pressure as ANF looks to sell through its 47% increase in inventories.

Taiwanese Retail is Bullish Due in Part to Chinese Tourists - Renewed confidence among Taiwanese consumers and ever increasing arrivals of deep-pocketed Chinese tourists is sparking a retail revival here. Department stores are riding the boom and at least eight major complexes are slated to open over the next two years. Consumer confidence is up in Taiwan and corporations are raising salaries slowly but steadily. Some industry experts expect the shopping boom to continue into the second half of the year. Even if sales by Taiwanese slacken, there could be an increase in sales from Chinese tourists if individual travel is allowed next year. Taiwan currently requires Chinese tourists to join tour groups. Restrictions on tourists from the mainland were relaxed in July 2008, and this year 1.2 mm Chinese are expected to visit the island, displacing the Japanese as Taiwan’s top visitor group. Many Chinese come to Taiwan to shop for luxury goods. Prices are lower, mainly because Chinese shoppers can circumvent the luxury tax in their country. <wwd.com/retail-news>

Hedgeye Retail’s Take: Not often on the radar map of many domestic players, it sounds like Taiwan may become a future growth opportunity. With that said, China controls the spigot in terms of Chinese tourist visits, which makes this still a riskier market over time.

Facebook Goes Places - Facebook is hoping to crack the location market with its new offering called Places, a geolocation feature that enables Facebook’s 150 million mobile users to broadcast their location through their Facebook status windows via a smartphone. <internetretailer.com>

$500 Suit is the Sweet Spot for Men's Suit Market - With their popularity bolstered by the lingering recession, branded and private label offerings hovering in the $500 retail range are continuing to gain traction. “The $495 suit has become a meaningful price point,” said Jim Ammeen, president and chief executive officer of Neema Clothing Ltd. “We’ve definitely seen a large increase [at this price] over the past few years in both branded and private label merchandise,” said Ron Wurtzburger, president of Peerless Clothing International. Brands such as Calvin Klein, DKNY, Lauren by Ralph Lauren and Haspel — strong names in the consumer’s mind — are among those getting a boost during these tough times. The men’s suit market overall continues to feel the impact of the economic malaise that just won’t release its grip on the U.S. According to The NPD Group, overall suit sales in department stores dropped 10% in July 2010 compared with 2009 — and that was on top of a 24% decline in 2009 versus 2008. <wwd.com/markets-news>

Hedgeye Retail’s Take: While $500 may be the bogey on price, it still seems like the economy is the bogey on demand. The bottom line here is suits are likely to benefit from an improved employment picture. Importantly, advancement in quality out of Asia will continue to be a key driver behind lower priced tailored clothing.

Mammut Sales Growth Slows in 1H - Sales growth has slowed considerably at Mammut Sports Group since April, according to first half financial data released Wednesday by its parent company Conzzeta Group of Zurich. Conzzeta said its Mammut Sports Group generated net sales in the first half of 2010 of 95 million Swiss francs ($87.9mm), up just 1.2% from CHF 93.9 million ($83.3mm) in the first half of 2009. <sportsonesource.com>

Hedgeye Retail’s Take: We wonder if the slowing demand is weather related (after all it wasn’t just abnormally hot in the US) or something more specific with this high-end outdoor brand. Domestically, there is no question that outerwear has been most impacted by record heat.

New Technology Offers More Efficiency to Leather Industry - US-based software engineer Spartanics has launched a new product named Finecut Laser Die Cutting to help make the leather cutting process more efficient by using barcodes to automate job changeovers within seconds. <fashionnetasia.com>

Hedgeye Retail’s Take: Sounds like this may be an extension of technology already in use in the textile industry aimed at reducing waste and creating more precise seams.

Levelwear to Launch Minor League Baseball Line - Levelwear, a brand division of The Accolade Group, recently signed a multi-year license agreement with Minor League Baseball (MiLBTM), to create a line of apparel that will showcase its patent-pending technologies - High Definition Lithography(HDL) and Level FX imagery. <sportsonesource.com>

Hedgeye Retail’s Take: Expect the technology to allow for vivid photographic imagery screen printed on the apparel. The manufacturer describes the product as “wearable art”.

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08/20/10 08:08 AM EDT

Lover's Hour

“Each moment of a happy lover’s hour is worth an age of dull and common life.”

-Aphra Behn

I love my family, my firm, and my macro model. There is no hiding love – especially after the lover’s hours we’ve had on the short side of the US stock market for the past few days and weeks. Winners love to win.

No, dear Bullish Sirs – this isn’t about slapping you in the face this morning. This is all about a man named Mucker showing you the love. The love of something that brutish men of markets could never understand – the love of a woman.

If Aphra Behn were to join the ranks of we who are wedded to our writings, I think she’d have sufficiently stirred the pot of conventional market wisdoms too. In the 17th century she became one of the first professional female writers in England. Per Wikipedia, “She has since become a favorite among sexually liberated women.”

Having been ball-and-chained to plenty a Wall Street trading desk in my day, the liberation associated by this great country’s freedom of speech has made me a very happy man. The love I have of seeing the conflicted and compromised walls of the Fiat Republic fall has no end.

Being Nemo in the fishbowl has its perks. I get fed a lot of emails. Most of the notes that people take the time to send me are very thoughtful and additive to my risk management process. Once in a while, I get sent something very special.

While the bullish brutes were running up the buy-and-hope score in July, an interesting player in this game made my day. He sent me a note that accused me of being married. He wrote, and I quote, that “you sound like a wife defending her husband."

Now, both on and off the ice, I have been called a lot of things in my day, but never a wife. If I could be someone’s wife, I would definitely be Laura’s.

Altogether, being wed to a view in this business can be as dangerous as being single minded. Being wed to a flexible, multi-factor, and multi-duration investment process is something I may forever wear as a badge of honor that some men in this business will love to hate. I’m cool with that though – I don’t foresee seeking the love of another man.

Let’s end this diatribe with what players in this game really feel. They hate being wrong. They love being right. For me, I have been happily wed to the bearish view since I put it on the tape on April 16th. Let’s get back to the positive messaging I am working hard on this week – winning and the love:

Unemployment – yesterday’s jobless claims number was an absolute bomb. As my teammate Allison Kaptur summarized yesterday, initial jobless claims rose 12k last week to 500k, the highest level since November 2009. Consensus had called for a small decline. Rolling claims rose 8k to 482.5k, also the highest level since last November. We have been looking for the range of 375-400k as the maximum level for unemployment to fall meaningfully, but with claims moving the wrong direction, the spectre of rising unemployment looms.

US Economic Growth – JP Morgan joined Goldman Sachs yesterday as the latest sell-side firm to cut their GDP estimates for the back half of 2011 closer to ours. As a reminder to all of those who are wedded to the bullish case that “earnings are good and US growth is good”, there is a very high likelihood that US GDP growth comes in at or below the Hedgeye estimate (established via my love letter dated July 1, 2010) of +1.7% for Q3.

US Housing Double Dip – we fully realize that our current 2011 US GDP estimate of +1.7% doesn’t equate to what newsy pundits call a “double dip.” To be clear, we are calling for a significant sequential slowdown in US GDP growth over the course of the next 3-6 months and an acturial “double dip” in US Housing prices over the course of the next 6-12 months (our Q3 Macro Theme call for Housing Headwinds lays out the case for US Home Prices in the Case-Shiller series to drop -15-20% from the cycle-highs that are being established here in Q3).

Now what would my lover’s hour of watching the US futures trade lower again this morning be without giving my bullish friends both a line and a catalyst?

The Line – the next line of immediate term TRADE support for the SP500 is 1058. Below that, the gravitational forces of chaos theory don’t signal any significant support for the SP500 until 1041. That line would register as a 3 standard-deviation move in our immediate term model and a very good spot to be covering shorts, buying some longs, and loving happy hour thereafter.

The Catalyst – the next catalyst is starring us right in the eye on August 24th when the next bomb is dropped on the bulls barns via Twitter, Facebook, and email in the form of the US Existing Home Sales report.

As Oscar Wilde said, “the world has grown suspicious of anything that looks like a happily married life.” But the investment world as the Fiat Republic knows it is ending.

‘Tis Lover’s Hour in New Haven, CT. Stay transparent, my friends.

KM

Keith R. McCulloughChief Executive Officer

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08/20/10 07:38 AM EDT

THE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - August 20, 2010

As we look at today’s set up for the S&P 500, the range is 35 points or 1.6% (1,058) downside and 1.6% (1,093) upside. Equity futures are trading below fair value as Asian and European markets fall amid a resumption of risk aversion; news flow has been light and volumes are thin. There are no economic indices scheduled for release today, and earnings are light, with only HRL and JMS reporting. Last night, DELL reported earnings which beat at EPS while reiterating June guidance.

Risk Managed Long Term Investing for Pros

INITIAL CLAIMS JUMP AGAIN... TO A 9-MONTH HIGH!

Risk Manager subscribers can access the post in it's entirety, and in real-time; This entire note was originally published at 9:03am ET.

______________________________________________________________________Initial jobless claims rose 12k last week to 500k, the highest level since November 2009. Consensus had called for a small decline. Rolling claims rose 8k to 482.5k, also the highest level since last November. We have been looking for the range of 375-400k as the maximum level for unemployment to fall meaningfully, but with claims moving the wrong direction, the spectre of rising unemployment looms.

A hedge fund pioneer looks at 30

MGM: MAINTAINING LOW CAPEX

MGM is severely under spending on maintenance capex. The good news is they can probably keep it up [down] through 2011.

We’ve always thought that maintenance capex in the casino industry needed to be 5-7% of revenues. It’s not the perfect measure but it’s good enough. Companies have either spent this much or under reported true maintenance. To its credit, MGM has historically spent in the 5-9% which means they are a) honest in their reporting and b) properly maintaining their properties. Certainly, given the company’s exposure to the competitive LV Strip and its market positioning at the upper end of the spectrum, they do need to spend more.

The following chart shows MGM’s historical maintenance spend as a % of revenues and as a % of PP&E. Clearly, capex is way below normal levels on both metrics.

MGM plans on spending $200 million on maintenance capex this year and next year, representing about 3% of revenues. They can probably get away with it since they had fresh product heading into the downturn. MGM spent 9% of revenues on maintenance capex in both 2007 and 2008. However, they will have to play catch up in 2012 and therein lies the problem. Normalized capex will eat into its free cash flow. In 2011, we project MGM will generate $225 million in free cash flow but only $75 million if we normalize maintenance. That translates into a paltry 2% free cash flow yield on the current stock price. Note that for this analysis we are using a modified free cash flow measure that includes hypothetical JV distributions and income tax benefits. True free cash flow will undoubtedly be negative next year.

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